"I'M BUYING U.S. SHARES"

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"I'M BUYING U.S. SHARES"

DOES THE BROAD FEAR OF THE FINANCIAL CRISIS 2007 - 2009 LEAD TO UNDERVALUATION OF

COMPANIES WHICH HAVE NOT EXPERIENCED INFLUENCES FROM THE FINANCIAL CRISIS?

Authors: Andreas Blome Martyn Chabros Supervisor: Håkan Bohman

Student

Umeå School of Business Spring semester 2009

Master thesis, one-year, 15 hp

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Acknowledgments

The authors would like to thank Håkan Bohman their supervisor for supporting their thesis work with his knowledge in business research methodology and his great experience in guiding students through their research project.

Andreas Blome Martyn Chabros Umeå, the 27^th of May 2009

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Abstract

The starting point of this Master Thesis have been utterances of well known investors during the financial crisis which recommend to buy shares especially in the time of financial downturn because one could buy good performing companies at a low price.

This arouse the question if broad fear of market participants during the financial crisis of 2007 to 2009 leads to undervaluation of companies which have not experienced influences of the financial crisis.

The researchers found that this question must be answered positively.

The authors come to this result after they, in a first step, detected unaffected companies by observing the key financial indicators (earnings, book value and operating cash flow) of the 600 constituents companies of the S&P 600 Small Cap Index during the time period from 2004 to 2008 (before and during the financial crisis).

In a second step the writers selected one company out of all unaffected companies and carried out a valuation to find the fundamental (or intrinsic value) of this company. By comparing the fundamental value of the company with its share price they found that this company was undervalued.

In a third and last step the researchers discovered the indication that this undervaluation results from investors' fear, as they could show that a confidence indicator that measures the confidence of institutional investors correlates with the value of the S&P 600 Small Cap Index but not with the financial indicators (in this case EBIT and Book Value) of the constituents companies of the S&P 600 Small Cap Index.

Thus, the main research question if the broad fear of market participants leads to undervaluation of companies which have not experienced influences of the financial crisis of 2007 – 2009 must be answered positively, as mentioned before.

Moreover, the hypothesis: Markets can be inefficient in the times of the financial crisis 2007 to 2009, which the researchers established must be seen as true.

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Table of content

Acknowledgments ... I Abstract ...II Table of content... III Table of formulas and relationships ... VI Table of formula variables ...VII Abbreviations in alphabetical order ... VIII

1 Introduction ... 1

1.1 Background ... 1

1.2 Research purpose... 3

1.3 Research questions ... 4

2 Research strategy and design ... 4

2.1 Role of theory... 5

2.2 Epistemological considerations... 5

2.3 Ontological considerations ... 7

2.4 Paradigmatic positions ... 8

2.5 Determination of the research strategy... 8

2.6 Research design... 9

3 Theory and hypothesis ... 12

3.1 Efficient Market Hypothesis (EMH)... 12

3.1.1 Summarized description ... 12

3.1.2 Forms of the Efficient Market Hypothesis ... 13

3.1.3 EMH and Fundamental analyses ... 14

3.1.4 Market anomalies ... 15

3.1.5 Interpretation of market anomalies... 16

3.2 Behavioural finance... 18

3.2.1 Summarized description ... 18

3.2.2 Phenomena of behavioural finance ... 18

3.2.3 Theories of behavioural finance ... 20

3.2.4 Summery of the behavioural finance and impact in the research work ... 21

3.3 Financial crisis... 22

3.3.1 Causes... 22

3.3.1.1. Securitization... 22

3.3.1.2. Maturity mismatches ... 22

3.3.1.3. Structured products gain popularity ... 23

3.3.1.4. Consequences ... 25

3.3.2 From a sub-prime to a global financial crisis ... 25

3.3.3 Influences on the real economy... 26

3.3.4 Market and emotions ... 29

3.4 Establish the hypothesis ... 29

4 Methods ... 30

4.1 Valuation models... 30

4.1.1 The economic value added ... 31

4.1.1.1. Introduction ... 31

4.1.1.2. Advantages and drawbacks ... 31

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4.1.2 Multiple analysis ... 31

4.1.3 Discounted cash flow model ... 32

4.1.4 The dividend discount model ... 33

4.1.5 Residual Earnings Model ... 34

4.1.6 The Abnormal Earnings Growth Model... 35

5 Research strategy in practice... 36

5.1 Concepts in question ... 36

5.2 Finding adequate measures of the concepts ... 38

5.2.1 Measures of company's financial performance ... 38

5.2.2 Measure of fundamental value ... 40

5.2.3 Measure of market value ... 40

5.2.4 Measure the market participants confidence ... 40

6 Seeking not influenced companies ... 41

6.1 Definition of selection criteria... 41

6.2 Definition of research sample ... 41

6.2.1 The research sample ... 41

6.2.2 Exclusion of the telecommunication industry ... 42

6.3 Definition of seeking concept ... 43

6.3.1 Difficulties... 43

6.3.2 Basic idea ... 43

6.3.3 Defining an observation period ... 44

6.3.4 Mathematical Implementation of the seeking concept... 45

6.4 Selecting of an appropriate case for further investigation... 46

7 Valuation of a selected case ... 47

7.1 Selecting an appropriate valuation model ... 47

7.1.1 Necessary financial Data ... 49

7.1.2 Estimating the cost of capital ... 50

7.1.2.1. Estimating the risk free rate ... 51

7.1.2.2. Estimating Beta ... 51

7.1.2.3. Estimating the market risk premium ... 52

7.1.2.4. Calculation of the cost of equity capital... 53

7.1.2.5. Criticism of the CAPM method for estimating the cost of equity capital 53 7.1.3 The forecast horizon and growth rate of RE after the forecast horizon ... 53

7.1.3.1. Determination of the forecast horizon... 53

7.1.3.2. Determination of the growth rate of RE after the forecast horizon... 54

7.1.4 Calculating the value of the selected case according to the RE model. ... 54

7.1.4.1. The starting position... 55

7.1.4.2. Detailed description of the calculations ... 55

7.1.5 Result of the company valuation and comparison with the actual share price. 56 7.2 Undervaluation and emotional driven markets ... 57

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8 Conclusions ... 58

8.1 Description of results ... 58

8.1.1 Possibilities of generalisation and limitations of the study ... 59

8.1.2 Reliability and Validity of the results ... 59

8.1.2.1. Reliability ... 60

8.1.2.2. Validity... 61

8.2 Lessons from the research work... 63

8.2.1 Recommendations for further research in this study area ... 64

References ... 66

Books:... 66

Articles: ... 66

Working papers ... 68

Master Thesis ... 68

Articles published electronically:... 68

Websites ... 69

Table of appendix:... 70

Appendix ... 71

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Table of formulas and relationships

1) EVA = (ROIC – WACC) * K ... 31

2) MV = D1 / (1 + k) + D2 / (1 + k)² + ... + Dn / (1 + k)ⁿ+ TV / (1 + k)ⁿ... 33

3) TV = D n+1 / CE - g ... 33

4) Residual earnings1 = Earnings1-(Required return*Investment0)... 34

5) Residual earnings = (ROCE - Required Return on equity)*Book value of common equity34 6) V^E0 = B0 + (RE1 / pE) + (RE2 / p²E) +…+ (RET / p^TE) ... 34

7) V^E0 = B0 + (RE1 / pE) + (RE2 / p²E) +…+ (RET / p^TE) + (RET+1 / pE – 1) / p^TE... 34

8) V^E0 = B0 + (RE1 / pE) + (RE2 / p²E) + (RE3 / p³E) +…+ (RET / p^TE) + (RET+1 / pE – g) / p^TE34 9) Abnormal earnings growtht = Cum-dividend earningst - normal earningst... 35

10) Cum-dividend earningst = Earningst + (p^E-1) * dividendt-1... 35

11) Normal earnings = p_E * Earnings_t-1... 35

12) V^E₀ = 1 / p_E - 1[Earn₁ + AEG₂ / p_E + AEG₃ / p²_E + AEG₄ / p³_E + ...] ... 35

13) Earnt – (pE – 1)Bt-1 = [ROCEt – (pE – 1)]Bt-1... 49

14) Ending book value = Beginning book value + Comprehensive Income – Net dividends . 50 15) k_s = r_f + [E (r_m) – r_f] (beta)... 50

16) k_s = r_f + [E (r_m) – r_f] (beta) ... 53

17) Ending equity = Beginning equity + Total (comprehensive) income – Net payout to shareholders... 55

18) B_t = B_t-1 + Earn_t – d_t... 55

19) Earnt / Bt-1 = ROCEt... 55

20) RE_t = Earn_t – (p_E – 1)B_t-1... 55

21) V^REt0 = REt / p^tE... 55

22) V^RE0 = V^RE10 + V^RE20 + V^ER30 + … + V^RET0... 55

23) CVT = (RET+1 / pE – 1) ... 56

24) CVT = (RET+1 / pE – g) ... 56

25) CV0 = CVT / p^TE... 56

26) V^E0 = B0 + V^RE0 + CV0... 56

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Table of formula variables

AEG Abnormal Earnings Growth

B Book Value

(beta) Beta estimation of the company

CE Cost of Equity

CV Continuous Value

D Dividend in a certain year

d Dividends

E (r_m) Expected return on the market Portfolio

Earn Earnings

EVA Economic Value Added

g Residual earnings growth rate

K Capital stock of the company at the beginning of year

ks Cost of equity

MV Market Value

n Number of years in the explicit period

p^E Required rate of return on equity (where 5% = 1 + 0,05)

r_f Risk-free rate

RE Residual Earnings

ROCE Return On Common Equity

ROIC Return for Invested Capital

T Time after the forecast horizon

TV Terminal Value

V^E Value of Equity

V^RE Value of Residual Earnings

WACC Weighted Average Cost of Capital

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Abbreviations in alphabetical order

ABCP Asset Backed Commercial Papers

ABS Asset Backed Securities

AEG Abnormal Earnings Growth Model

AIT Applied Industrial Technology Inc.

BPS Book value Per Share

CAPM Capital Asset Pricing Model

CASY Casey's General Stores Inc.

CDO Collateralized Dept Obligations

CDS Credit Default Swaps

CI State Street Confidence Index

CP Commercial Paper

CW Curtiss-Wright Corp.

DCF Discounted Cash Flow Model

DDM Dividend Discount Model

DPS Dividends Per Share

EBIT Earnings Before Interest and Tax

EMH Efficient Market Hypothesis

EPS Earnings Per Share

EVA Economic Value Added

GDP Gross Domestic Product

HAIN Hain Celestial Group

IFRS International Financial Reporting Standards

IMF International Monetary Fund

JJSF J & J Snack Foods

LNCE Lance, Inc.

MVA Market Value Added

NYSE New York Stock Exchange

P/B Price to Book Ratio

P/E Price to Earnings Ratio

PEET Peet's Coffee

PFCB P. F. Change's China

PhD A Doctor of Philosophy degree

PPD Pre-Paid Legal Services

P/S Price to Sales Ratio

RE Residual Earnings

repo Repurchase Agreement

ROCE Return On Common Equity

ROIC Return On Capital Invested

RRGB Red Rubin Gourmet

SAM Boston Beer Company

SEC Security and Exchange Commission

SIV Structured Investment Vehicles

SSYS Stratasys Inc.

USD US Dollar

US-GAAP United States Generally Accepted Accounting Principles

WACC Weighted Average Cost of Capital

WDFC WD-40 Company

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1 Introduction

In the first paragraph of this study the authors will describe from which background their research project arrived. After the formulation of the main research question they will explain the purpose of their study and what goals they want to achieve with it. In a next step they will also establish three more research questions which will guide the whole work to the final conclusions. Moreover the authors will discuss basic methodological assumptions they make and will present the research strategy as well as the research design they choose for their work.

1.1 Background

The emergence of financial crisis (2007-2009) was caused by many factors. However, the spark, which has an impact on wide spreading it, was the depreciation on the American housing market in the first quarter of 2006. The market naively expected that the prices of property could increase indefinite and it did not create any system security (regulations), which could protect the economy from wide spreading the default from real estate market to others industry.¹ The first victims of the wave of collapsing property industry were sub prime lenders, whose market role relied on lending money to borrowers, who did not meet the requirements of mainstream lenders. Such borrowers had to pay higher interest rates, because the risk of insolvency was significantly higher and their financial situation could change rapidly to the worst in the time of their financial problems.² Moreover most of sub prime loans were not given to finance the purchase of a house, but they were sold to the customers, who wanted to refinance their existing loans.³

The process of gradual bankruptcy of such risk lenders caused decline of the value of sub prime asset-basked securities, which were possessed by hedge funds of big investment banks such as Bear Stearns, Merrill Lynch or BNP Paribas.⁴ The worst the situation of the sub prime-lenders, the cheaper and less liquid become the derivates based on their performance.

Moreover these derivatives were significant part of the assets of these investment banks and they could lead them to the state of bankruptcy, which could have an impact on creating a dangerous situation in the world financial market.⁵ Such dangerous situation undermined the trust of the big financial players to each other, which were uncertain how many of the toxic financial instruments could possess its business counterparties and as a result it caused the reduction of the credit line. The banks stopped borrowing themselves on three-months period,

1 Acharya / Philippon / Richardson / Roubini (2009), p. 89

2 Gerardi / Lehnert / Sherland / Willen (2009), p. 7

3 Gerardi / Lehnert / Sherland / Willen (2009), p. 8

4 Acharya / Philippon / Richardson / Roubini (2009), p. 89

5 Acharya / Philippon / Richardson / Roubini, (2009), p. 93

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reducing the inside branch activity to only overnight borrowing.⁶ The widespread of distrust among the banks lead to decrease of their liquidity and finally to the reduction of loans for the entrepreneurs, who could not continue or start investments. These interconnections between the different sectors of economy and unhealthy financial system caused the creation of self- propelled spiral, which lead to decreasing the Gross Domestic Products, the value of stock prices and increasing of unemployment rate. It is very important to stress that the USA economy is the biggest in the world⁷ and it has a great influence on the economies of other nations in a globalizing world. That’s why the paramount position of the USA economy was decisive of wide spreading the financial crisis to other countries. According to the data, the economy of USA shrinks of 1,6% in the last quarter of 2008 (in a comparison to previous quarter), 27 European countries of 1,5% and Japan 3,2%.⁸ The unemployment rate increased in USA from March 2008 to March 2009 of 3,4%⁹, in European Union area from February 2008 to February 2009 of 1,1 %¹⁰ and in Japan from February 2008 to February 2009 of 0,6%. Finally, the value of the indexes of the biggest stock markets also decreased: the London Stock Exchange Market from 1390 (3^rd April 2008) to 612 (3^rd April 2009)¹¹, S&P 500 from 1350 (3^rd April 2008) to 842,5 (3^rd April 2009)¹² and Japanese Nikei from 68 (3^rd April 2008) to 52 (3^rd April 2009).¹³ At worst, the predictions for the economy are not optimistic, the GDP of the most countries will slow down in the 2009 and world GDP will shrink down of 0,5 - 1% in 2009 according to IMF.¹⁴ Moreover the world trade, which was the lever of increasing world GDP in the last decade, will also be lower of 2,1 % than in 2008.¹⁵ Obviously the data shows a black picture of the whole world economy.

However, in between this abundance of ongoing bad news reporting the economy goes from bad to worse, some authors of newspaper articles and prominent investors recommend that this time is the best time for buying shares. The probably most famous investor Warren Buffet for instance recognizes a widespread fear in the market and sees the chance, that in this point of time, substantial companies can be bought at an attractive price. He claims that shares will outperform cash over the next decade.¹⁶ Another example is the article "Cheap shares snap up now" which draws the same picture. It is stated that the decline of the stock markets brings

6 Acharya / Philippon / Roubini (2009), p. 92

7http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

8http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

9 Bureau of Labour Statistics (2009)

10 http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

11 www.google.com/finance

14 International Monetary Fund (2009)

15The World Bank (2008)

16 Wearden (2008)

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good opportunities especially in the field of normally expensive and conservative shares.

Moreover the investors could find company stocks which are unevaluated at the moment because the high volatile market has not brought them down.¹⁷

So on the one hand the most common economic indicators show that the economy is in the worst downturn since the great depression and on the other hand some people in the financial scene are of the opinion that exactly this downturn is a good opportunity to invest in shares because most of these stocks are on a historical low level. Especially in the article "Cheap shares to snap up now" it is emphasised that the financial crisis has not put down all companies and moreover that companies might under valuated.¹⁸

The resulting question for any investor in these days is of course, who is right? Is it possible that a company has not experienced any influences resulting from the financial crisis? Isn't it the case that the financial crisis has an impact on everything, even on the real economy? Can we find really companies which are unevaluated and which might be a chance of abnormal earnings when the economy recovers? And if this is the case, which companies are unevaluated and to what extent? Or are the authors of these kinds of newspaper or magazine articles wrong and shares are valuated correct by the market?

All these questions an investor (or a common person following the economic developments) might keep in mind these days and they can be summarized to one research question which answer is the subject of this study:

"Does the broad fear of the financial crisis 2007 - 2009 lead to undervaluation of companies which have not experienced significant influences from the financial crisis?"

1.2 Research purpose

The results of this study will detect a case of a listed company which is undervalued by the market participants because of the broad fear that dominates the financial markets in the time of the financial crisis 2007 - 2009. The study will prove that particular firms have not experienced influences resulting from the financial crisis 2007 – 2009. After selecting one case which will be investigated in a deeper fashion the study will detect that the firm drop in its share prices for no economic reason but because of the broad fear of market participants who are uncertain about the future.

17 Hill (2008)

18 Hill (2008)

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1.3 Research questions

To achieve the main goal of the research: Prove that the financial crisis leads to particular undervaluation of firms which are not influenced by the impact of the financial crisis because of broad fear of market participants, several Sub-questions will be answered.

First, the question if there are existing listed companies which demonstrate that they are in no way influenced by the financial crisis will be detected. Some examples for influences which result from the global financial crisis might be: higher refinancing costs, decrease or increase of demand, difficulties in loan commitments, etc. In this study the authors will show that none of the selected companies which should be subject to further investigation are exposed to such influence factors.

Second, the question if the selected firms are under valuated will be scrutinized. The authors will choose one case out of the uninfluenced firm and present an assessment of its firm value and an argumentation why they believe that their suggested estimates are true values of the company. Furthermore, they will compare their estimations with share prices which allows them to make statements if and to what extent the valued company is undervalued.

The last question to be answered is if that under valuation is a result of the broad fear of market participants or if there might be other reasons for that. To answer this question the authors will examine how the financial performance (indicators) of the selected company and S&P 600; the share price of the selected company and S&P 600; and an investor confidence index interact. If the share price drops in the same fashion as the confidence index and if at the same time the financial performance stays stable this must be seen a strong indication that the market is not driven by rational but emotional investors.

There are three sub-questions:

• Are there companies to find which are not influenced by the financial crisis?

• Are these firms under valuated?

• Does this under valuation result from broad fear of market participants during the financial crisis?

The consideration of these sub-questions will allow the authors to answer the major question of this study.

2 Research strategy and design

In this paragraph the authors will discuss theory related, epistemological and ontological assumptions in relation to the research topic. Based on these considerations they will determine a research strategy which represents the fundament of this study.

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2.1 Role of theory

Thinking about the appropriate research strategy starts with considerations about the role of theory. Any research is in some way linked to theory. There are two views of the relationship between theory and research: Deductive and inductive theory.¹⁹ The nature of deductive theory is that at first a particular hypothesis is established which arises from already known aspects of a certain field of study and from theoretical considerations which are related to it.

After that the established hypothesis is tested by finding empirical evidence that this hypothesis is true or false. The last step is a feed back or the revision of former theory.²⁰ The inductive is the opposite of the deductive approach. In this instance at first, data is collected. After that it is tried to find relations between the observations. At the end the relationships are generalized to create a new theory.²¹ Of course a clear delineation between these two approaches is not possible: "However, just as deduction entails an element of induction, the inductive process is likely to entail a modicum of deduction."²²

However, some researches add to these two categories another one, which is called the functional theory. That kind of theory combines the elements from deductive and inductive theory and it is especially useful in the area of psychological research.²³

This work follows the deductive approach. This study is related to the Efficient Market Hypotheses and to the theories of behavioural finance because these theories explain on the one hand when, why and how markets act efficient and rational and on the other hand under what circumstances markets act irrational and inefficient. Resulting from this theories this study aims to clarify whether the fear of the financial crisis leads to a undervaluation of particular companies or if the market acts even in this special situation rational, logically and efficient. In this study it is tested if and how these theories work under the conditions of the current financial crisis and if the established hypotheses can be proved as true.

In other words an established hypothesis which results from existing theories is tested by empirical data to state if the hypotheses hold true. This procedure reflects a typical deductive approach.

2.2 Epistemological considerations

After defining the role of theory epistemological considerations are taken into account as a second step to the appropriate research strategy of this work. Epistemology deals with the question of what should be seen as knowledge in a certain field of study. The main question is

19 Bryman / Bell (2007), p. 11

20 Bryman / Bell (2007), p. 11, 12

21 Bryman / Bell (2007), p. 13, 14

22 Bryman / Bell (2007), p. 14

23 Graziano / Raulin (2000), p. 38

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if social relationships should be studied in the same way as the naturalistic science.²⁴ The primary epistemological positions are positivism, realism and interpretivism.

The positivistic position is characterized by different attributes. First of all only phenomena that can be proved by senses can be seen as reality. Moreover the objective of theory is to create hypotheses. The testing activity of this hypothesis allow to explaining the reality.

Further more knowledge is generated by examining the real world and summarizing the findings of these examinations in basic relationships. In addition to that scientific examinations must be objective. The last important characteristic of the positivist position is that a scientific study has to deal with scientific statements and not with normative statements.²⁵

The second epistemological position is realism. In general realism has the same attributes as the positivistic position that is: natural and social science should use the same approaches when collecting and explaining data and the conception that there exists an external reality which is examined by scientists.²⁶ Apart form these basic similarities there are two main forms of realism the empirical realism and the critical realism.

Empirical realism means that reality can be understood by employing suitable methods. The critical realism view includes not only the examination of the reality but also the exploration of events and discourses of the social world.²⁷

The last epistemological position is the interpretivism. This position is almost the opposite of the positivistic view. Interpretivism distinguishes between the social action of individuals and the naturalistic science view of reality. According to the interpretivitic reality is a social construct. Because of that the scientist must analyse the social behaviour to understand the reality.²⁸

Regarding this study it is difficult to determine an epistemological position. On the one hand the study will examine the development of share prices and after that analyse them and draws conclusions which result from the analyses. In this case the scientists observe a subject (share prices) from a outstanding perspective which can not be influenced. This train of thoughts would lead clearly to a positivistic epistemological position. On the other hand is the development of share prices a result of supply and demand and one step further the supply and demand is a result of social interaction. It deals with how market participants assess the actual and future economic situation. The people assessment depends on confidence or fears

24 Bryman / Bell (2007), p. 16

25 Bryman / Bell (2007), p. 16

26 Bryman / Bell (2007), p. 18

27 Bryman / Bell (2007), p. 18

28 Bryman / Bell (2007), p. 19

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in the present and in the future. In short share prices are consequences of complex social interaction. When this study claims to examines share prices against the background of the financial crisis²⁹ the only suitable epistemological position which allows to explaining and hence understand the development of share prices is the interpretivistic position.

Because this study includes both the outstanding objective scientist who examines invariable facts and tries to draw his conclusions from them and the researcher who wants furthermore understand why the in retrospect unchangeable data developed like this³⁰ the most appropriate epistemological position is the critical realism because first: "Realism shares two features with positivism: a belief that the natural and the social science can and should apply the same kinds of approach to the collection of data and to explanation, and a commitment to the view that there is an external reality to which scientists direct their attention."³¹, and in addition to that: " … critical realists unlike positivists are perfectly content to admit into their explanations theoretical terms that are not directly amenable to observation. As a result, hypothetical entities to account for regularities in the natural or social orders (the generative mechanisms to which Bhaskar refers) are perfectly admissible for realists, but not for positivists."³²

2.3 Ontological considerations

After determining a deductive theory approach and a critical realistic epistemology position for this work the next step to the appropriate research strategy is to establish the ontological position of the study. In general there are two major positions which reflect opposite views.

"The central point of orientation here is the question of whether social entities can and should be considered social constructions built up from the perceptions and actions of social actors."³³

The term objectivism describes the view that social phenomena (social reality) are existing separately or independent from social actors.³⁴ The constructivist view on the other hand claims that this social phenomena or social reality is not existing independent from the social actors but it is created by them.³⁵ In other words reality does not only exist out there but it is created by participants of social life by interaction.

This study in which specific relationships of stock markets should be examined the objectivistic position is of major importance. In this study market data must be collected and

29 In the Situation of a crisis emotions and beliefs play even a larger role

30 Especially related to the behaviour of finance

31 Bryman / Bell (2007), p. 18

32 Bryman / Bell (2007), p. 18

33 Bryman / Bell (2007), p. 22

34 Bryman / Bell (2007), p. 22

35 Bryman / Bell (2007), p. 23

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analysed. These tasks require a strict objective attitude. Only when it comes to the analyses of why the share prices developed like they did the ontological position changes a very little step in the direction of constructivism because this question deals with the behavioural of finance and hence with social interaction.

2.4 Paradigmatic positions

Since ontological and epistemological assumptions are the basement of business research it is fundamental to understand the ontological and epistemological assumptions authors make in their research papers and the relationship between these two.³⁶ Because paradigms cluster different beliefs of what and how some specific topics should be studied and moreover how the results should be interpreted³⁷ they are a good possibility to summarize epistemological and ontological assumptions.

In the field of business studies there are four main paradigms which are clusters of certain assumptions: functionalist, interpretative, radical humanist, radical structuralist.³⁸

For this study the most important is the functionalist paradigm which combines an objectivist view on reality and a regulatory research purpose. Especially the data collection and analyse part of this study will be mainly influenced by this paradigm. Only when it comes to the investigation of possible reasons of certain developments the interpretative paradigm which combines a subjectivist view on reality with regulatory research purpose guides the further discussion.

2.5 Determination of the research strategy

Finally, after discussing all important points related to the field of research strategy, a statement on an appropriate research strategy can be made.

Although the distinction of between qualitative and quantitative research strategy is seen as not useful³⁹ the authors will use this differentiation because it combines and includes the assumptions which had been made so far and gives (against the background of these assumptions) a general orientation how business research should be carried out.⁴⁰

The appropriate research strategy results from the assumptions which had been made:

• A deductive approach to the use of theory

• An epistemological position of a critical realist

• Mainly a strict objectivistic ontological position

• Mainly an underlying functionalist paradigm for the business research

36 Bryman / Bell (2007), p. 25

37 Bryman / Bell (2007), p. 25

38 Bryman / Bell (2007), p. 25

39 Bryman / Bell (2007), p. 28

40 Bryman / Bell (2007), p. 28

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From these assumptions results a mainly quantitative research strategy. Because the authors wanted, to a certain extent, also answer questions concerning underlying relationships which might have lead to the observed developments, the study will in some parts, to a very small extent, fluctuate from an otherwise strict quantitative research strategy.

2.6 Research design

After determining the research strategy which should be the fundament of this study, another important point is discussed: What research design should this study follow?

The research design fulfills the important role of guiding the data collection. It is a method of completion the data by the researchers.⁴¹

The first type of research design – the experimental design – relies on different combinations of two variables, of which one is dependent from the other. The change of the independent variable has an impact on the dependent variable.⁴² That kind of research is conducted in two kinds of surroundings: laboratory or field and observation groups are exposure to the manipulation of the independent variable.⁴³ Such research design allows to measure, the correlation between the independent and dependent variable. Obviously, that research design has the delimitations, because with this kind of research design it is not possible to measure the interaction between more variables and thus it is useless to apply for a more complicated reality such as society, sophisticated economical models. Therefore, the authors consider that this type of research design will not support their research which deals with many variables like company performance, share prices and confidence indices and in addition to that (to a small extend) with immeasurable (behavioral finance) factors.

The cross-sectional design bases on the collection of different kind of data for more than one case in a particular single time in order to find relations between them. The purpose of this kind of research design is suitable to find variations between different cases.⁴⁴ Such research design is especially useful to detect the deep difference between some cohorts or samples.⁴⁵ However, the main obstacle of using this type of research design in this research paper is connected with the data collection in only one single point of time. The authors think that the data, which comes only from one single particular moment, can not fully give an answer if the theory (Efficient Market Theory) works during the current financial crisis (the whole financial crisis has been lasting for two years now). Further more, the authors are of the opinion that their observations should be repeated a few times to give a clear answer if particular theory

41 Bryman / Bell (2007), p. 40

42 Graziano / Raulin (2000), p. 50-51

43 Bryman / Bell (2007), p. 45, 46

44 Bryman / Bell (2007), p. 65

45 Graziano/ Raulin (2000), p. 152

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works under these specific conditions. That’s why this type of research design should not be fully applied by the authors in their work. However, the cross-sectional design is in some extent applicable for this work, because it puts pressure on the variation between the cases.

The examination of many cases can be useful regarding the detection of companies which are not influenced by the financial crisis. A possible scenario might be to determinate certain criteria a company must fulfill to be "not influenced" by the financial crisis. That’s why some elements of this type of research design are going to be implemented in this work.

Longitudinal design concentrates on changes, which are done during a specific period of time.

In other words, the researchers collect data from different points in time in order to compare them.⁴⁶ There are two kinds of sample in this type of research design: panel study and cohort study. In the panel study, the choice of sample is done randomly among the population and the collection of data is conducted during the meetings with the individuals or organizations at least twice times. Whereas the cohort study includes the sample of the entire population, which possesses some special characteristic, which can be: the purchase of the same products, the similar age, the same weight in particular period of time.⁴⁷ The biggest disadvantage of this kind research design can be the change of the sample during the long time of examination⁴⁸. In our case some of the analyzed companies can be withdrawn from the stock exchange because of the bankruptcy, especially in the times of the financial crisis. However, some parts of longitudinal research design can help the researchers to achieve satisfactory research results, because when not influenced companies should be detected, the performance of each of the companies must be observed over a longer period of time. If a company fulfils over this time certain requirements it can be seen as not influenced by the financial crisis.

It does not make any sense to comparing the fluctuation of stock prices before and during the financial crisis. The fluctuations of the stocks during the financial crisis are higher and it is caused by bigger uncertainty of market participants. During the financial troubles people have a bigger tendency to imitate the behavior of others, even thought they can behave irrational.

Such phenomena are called by the psychological researchers ‘herding behavior’.⁴⁹ This kind of behavior causes that people resign with taking their own decisions, which based on their own rational consideration and they follow for the action of others. Unfortunately the irrational decision of the herd causes ‘non-optimal Pareto equilibrium’.⁵⁰ The financial crisis in the countries of East Asia can prove the occurrence of investors’ panic, which was

46 Bryman / Bell (2007), p. 60

47 Bryman / Bell (2007), p. 60, 61

48 Graziano / M. Raulin (2000), p. 146

49 Morone / Samanidou (2008), p. 640

50 Morone / Samanidou (2008), p. 640

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characterized by the herd behavior during the financial troubles for local economies in 1997 and 1998.⁵¹ Furthermore we can not compare the current financial crisis with the similar events - Great Depression 1929-1935, because of the significant technological change, which allowed to developing the instruments on the financial market. In the face of the presented facts, the authors consider that longitudinal research design can not be used to examine the valuation of the stock prices before and during financial crisis. However, this type of research design can be helpful for collection of data in the different times during the financial crisis.

The comparative research design concentrates its efforts to find the difference or similarities between two contrasting cases. Such research is very useful in the cross-national comparisons, because it shows clearly the differences between two groups. These kinds of studies are of qualitative nature, because they highlight social issues such as: lifestyle, behavior, code of culture. This research design can not be applicable to this study, because the purpose of this paper does not rely on the comparisons between the groups of people and furthermore the main task of such type of study is to explain the differences based on the culture contexts. The comparative research design is mainly useful to conduct qualitative research than quantitative research. Because the grounding of this paper is a quantitative research strategy a research design which supports mainly qualitative research is unfavorable for this research work.

The authors think that the case study design is best suitable to their work because it combines the different types of research designs and it allows a deeper examination of a problem. The great advantage of this type of research design is also the possibility to detect the unique features of the analyzed problems.⁵² Furthermore, the authors are going to use this approach, because it offers the possibility to deduct tests⁵³ and the design fits for studies which include a deductive approach of the role of theory. Especially, the critical case might be helpful for this study, because it examines a hypothesis in order to hold or refute them. Such critical approach allows the authors to see the validity and reliability of Efficient Market Theory against the background of the financial crisis.

In summary it must be stated that the main research design of this paper will be the case study because it offers the possibility to analyze an entity in great detail. This will be important when it comes to the valuation of the selected case. Only in the part when uninfluenced companies should be detected, from which the case for the valuation will be selected, elements of the cross-sectional and longitudinal research designs will be included in the work because if one want to detect a company which is not influenced by the financial crisis it must

51 Baig / Goldfajn (1999), p. 194

52 Bryman / Bell (2007), p. 63

53 Bryman / Bell (2007), p. 64

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show stability in certain key indicators over a period over several years (before and during the times of the financial crisis). Only if a company maintains stability in these key indicators over the time it can be seen as not affected. If a case is selected out of the pool of unaffected companies the further examination of this case will follow only the case study design.

Because of the case study design must be seen as the main research design of this study.

The case study takes into consideration sample, which includes 600 companies which are constituents of the S&P 600. Such sample allows to generalizing the conclusions from our case to the whole market, because it consists of the companies from different industries and it is big. The case study design in this work will be relied on criteria which detect clearly if company is not affected during the time of financial disturbance in 2008 and 2009. The criteria will be based on basic accounting figures such as earnings, book value and cash flow, which will be apply to both company and its industries performance. Later, the researchers will choose a few companies, which meet the requirements of stable ratios. From these smaller sample will be selected one most hopeful companies in order to estimate its values based on the valuation models chosen. The next step will be the comparisons of the estimated company value with the actual market prices. If significant differences between market price and firm value can be observed, the author have some arguments for refutation of efficient market theory in the times of financial crisis.

3 Theory and hypothesis

In this paragraph the authors will describe all necessary theories and concepts which underlie the study topic. They will discuss the different theories in respect of the research topic and will come up with hypothesises resulting from this discussion.

3.1 Efficient Market Hypothesis (EMH)

3.1.1 Summarized description

This study deals with share prices and if the market sets these share prices correctly (efficient, retinal) in times of financial disturbance. Because of that economic theories are of main importance which occupy with the behaviour of stock market prices.

First of all, the studies which dealt with the behaviour of stock prices were made by Maurice Kendall. He analysed time series and found that stock prices do not reflect the prospects of a certain company, but that they seem to evolve randomly.⁵⁴

One of the probably best known theories in this field is the Efficient Market Hypothesis developed by Eugene F. Farma during his PhD studies in the year 1965. After two other

54 Bodie / Kane / Marcus (2008), p. 357

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publications of Fama concerning this topic, a summary of all his findings regarding the behaviour of stock prices was published 1970 under the title "Efficient capital markets: A review of theory and empirical work" in "The Journal of Finance". This publication is considered as a milestone in financial theory. The Efficient Market Hypothesis claims two main circumstances:

• Stock prices follow a random walk⁵⁵

• Stock prices fully reflect available information⁵⁶

Security prices change in respect to available information. If a new piece of information appears the security price changes respectively. The term "new information" is always considered as unpredictable. If a piece of information allows to interpreting the future, this piece of information is considered as today's news and as yet included in the share prices.

Because new information appears randomly (unpredictable), share prices behave randomly, too.⁵⁷

Security prices are considered to reflect all available information because markets are always analysed and observed deeply by investors and analysts in the hope to find more information or find information earlier than competitors, so that they can use arbitrage strategies to generate abnormal returns. So, the competition among investors and analysts leads to security prices which reflect all available information.⁵⁸

3.1.2 Forms of the Efficient Market Hypothesis

The empirical work carried out regarding stock price behaviour can be divided in three main groups. This three groups (referred to as forms) depend on the kind of information which is considered.⁵⁹

The weak-form includes only historical information, which is for example: past prices, trading volume or short interest rates. Because this data is publicly available and almost costless all investors are well informed and because of that prices are set efficiently. Generating abnormal earnings with the use of trend analyses is not possible.⁶⁰

The semi-strong-form includes information which is "obviously publicly available"⁶¹. This term includes historical information plus all public available information. Examples of this kind of information is: "past prices, fundamental data on the firm's product line, quality of

55 Fama (1965), p. 55

56 Fama (1970), p. 48, 49

58 Bodie / Kane / Marcus (2008), p. 359-361

59 Fama (1970), p. 414

61 Fama (1970), p. 414

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management, balance sheet composition, patents held, earnings forecasts, and accounting practices."⁶² Because this information is all publicly available the security prices should reflect this information. And because that is the case, it would be not possible to generate abnormal earnings, too.⁶³

The strong-form includes information of the past (historical information), all public available information and in addition to that information to which only specific groups have access to.⁶⁴ (Also referred to as insider information)⁶⁵ Possible insiders might be a few corporate officers because they have access to important information before the public. However, The Securities and Exchange Commission (SEC) put much effort in preventing insider trade.⁶⁶

3.1.3 EMH and Fundamental analyses

In respect to the research topic of this study it is important to point out the relationship between the Efficient Market Hypothesis and the Fundamental analyses because the authors will use fundamental analyses in a later section of this study to detect companies which not have experienced influences of the financial crisis and to give an estimate on the firm value based on fundamental data.

Fundamental analysts try to use earnings, dividend prospects, expectations of future interest rates, and risk assessments of a company to estimate an adequate stock price. The financial information needed is gathered from past and actual balance sheets. Also information from economic analyses, evaluation of the abilities of the management, the companies’ position in the industry and the future changes of the whole industry are added. If this data the analyst uses for his fundamental analyses is publicly available than this analyses will according to the Efficient Market Hypothesis give the analyst not the chance of generating abnormal returns.

This is because under the theoretical framework of the Efficient Market Hypothesis the analyst's analyse will not be better than any analyses of his rivals. Because there are many well informed analysts and investors its very hard to detect knowledge which none else has yet and which can give an analyst a competitive advantage.⁶⁷

In short: Under the theory of EMH, fundamental analyses can not provide an investor or an analyst the possibility of generating abnormal earnings. If the previous statement is true, why do the authors than wanted to carry out a firm valuation in this study and estimate the certain

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companies? If the EMH is right, than companies must be valued adequately and a firm valuation which relies on available data won't give the authors more insight.

3.1.4 Market anomalies

There are serious doubts in the research society that the EMH holds true in any case. The so- called "market anomalies" give a first indication, that the EMH might have some vulnerabilities and does not explain any price movement. Some examples for such anomalies are described in the following.

The P/E effect was detected by Basu. He found that: "During the period April 1957-March 1971, the low P/E portfolios seem to have, on average, earned higher absolute and risk- adjusted rates of return than the high P/E securities. This is also generally true when bias on the performance measures resulting from the effect of risk is taken into account."⁶⁸ Basu concluded from his findings that: "Contrary to the growing belief that publicly available information is instantaneously impounded in security prices, there seem to be lags and frictions in the adjustment process."⁶⁹ By that he criticises partly the theory of efficient markets.

Another anomaly is called the small-firm-effect and was discovered by Banz. He found that:

"On average, small NYSE firms have had significantly larger risk adjusted returns than large NYSE firms over a forty year period."⁷⁰ He pointed out that: "There is no theoretical foundation for such an effect."⁷¹, which mean that in this special case the EMH gives no explanation. The small-firm-effect after its detection by Banz has been complemented by Keim who found that: "… daily abnormal return distributions in January have large means relative to the remaining eleven months, and that the relation between abnormal returns and size is always negative and more pronounced in January than in any other month…"⁷² Because of that the name of the small-firm-effect was changed into the small-firm-in-January effect.

The neglected-firm effect was detected by the researchers Arbel and Strebel. They interpreted the small-firm effect differently in the sense that because small firms are often neglected by large institutional traders, information about such small firms is not that extensive. The lack

68 Basu (1977), p. 680

69 Basu (1977), p. 681

70 Banz (1981), p. 16

71 Banz (1981), p. 16

72 Keim (1983), p. 31

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of information results in higher risk which requires higher returns. However, the neglected- firm effect can't be seen as the strict market inefficiency.⁷³

The book-to-marked effect was established by Fama and French in the year 1992. The researchers found that: "…beta seemed to have no power to explain average security returns."⁷⁴ These findings have a great importance regarding the idea of efficient markets, because it claims that: "…a factor that should affect returns – systematic risk – seems not to matter, while a factor that should not matter – the book-market-ratio – seems capable of predicting future returns."⁷⁵

The last effect which should be mentioned here is the post-earnings-announcement price drift discovered by Ball and Brown in 1968. The researchers found that although the annual report of a company captures one-half of all information of this firm which was published during a year, the market does not adjust prices according to the abundance fast (as it is implied by the EMH), but more in a drifting fashion.⁷⁶

After describing the main market anomalies the question arises, if those anomalies must be seen as market inefficiencies (explanation not conform to the EMH) or as a form of risk premium (explanation conform to the EMH). If the anomalies turn out to be as market inefficiencies the authors have evidence that the efficient pricing of securities does not work at any circumstances and by that an indication that undervaluation of companies is possible and may be the case.

3.1.5 Interpretation of market anomalies

Several studies had been carried out by different researchers to answer the question whether market anomalies indicate market inefficiencies or risk premiums. Farma and French found that: "…stocks with higher 'betas' (also known as factor loadings) on size or market-to-book factors have higher average returns; they interpret these returns as evidence of a risk premium associated with the factor."⁷⁷ This means in other words, that company size and book-to- market ratios can be seen as proxies for fundamental risks. The higher returns of small firms and firms with a low book-to-market ratio are consistent with the EMH in the way that a different risk levels asks for different returns.⁷⁸

A similar study carried out by Lakonishok, Shleifer and Vishney offered almost the same findings (value stock outperform glamour stocks) is interpreted by the researchers in a

76 Ball / Brown (1968), p. 168–171

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different way.⁷⁹ They state that: "While one can never reject the 'metaphysical' version of the risk story, in which securities that earn higher returns must by definition he fundamentally riskier, the weight of evidence suggests a more straightforward model. In this model, out-of- favour (or value) stocks have been under priced relative to their risk and return characteristics and investing in them has indeed earned abnormal returns."⁸⁰ The researchers are of the opinion that analysts make evaluation errors in the sense that they overprice firms with good past performance and under priced firms with poor performance. When these evaluation errors are detected by the market and prices are adjusted value stocks outperform glamour stocks.⁸¹

These two studies are only two examples of research which is concerned with the question if the detected anomalies are market inefficiencies or a form of risk premiums.

Some researchers are even of the opinion that these anomalies have no other explanation than data mining. They argue that: "…if one reruns the computer database of past returns over and over and examines stock returns along enough dimensions, simple chance will cause some criteria to appear to predict returns."⁸² This idea becomes even more interesting when it was observed that some of these anomalies disappear after they had been detected. However, the examination of data not already researched (other security markets around the world revealed the same anomalies which had been detected before.⁸³

In summary it can be stated that the EMH is a grounding theory of the behaviour of stock prices and because of that an essential part of this research paper. The EMH states that market prices are set efficiently in the sense that they reflect all available information. Although some researchers doubt that the EMH does not cover every case (see anomalies) it is not clear if this anomalies must be seen as market inefficiencies or as a form of risk premium. Nevertheless the findings of anomalies has lead to remaining doubts if the EMH can really explain any price movement or if there are other factors influencing the pricing of securities.

This idea is especially interesting against the background of this research paper because if it is true that the EMH explains not all price movements than the security prices might be wrong priced. The detection of the true value of miss priced securities might then offers the possibility of earning abnormal returns when prices adjust again after market participants detected the miss pricing. Arguments for other factors influencing price changes offer another

79 Lakonishok / Shleifer / Vishney (1994), p. 1574

80 Lakonishok / Shleifer / Vishney (1994), p. 1574